What is due diligence?

Have you been talking about software company acquisitions,
and the phrase "due diligence" came up? Are you wondering just what "due
diligence" means?

Most legal definitions of due diligence say something like
"due diligence is a measure of prudence, activity, or assiduity, as is
properly to be expected from, and ordinarily exercised by, a reasonable and
prudent person under the particular circumstances; not measured by any
absolute standard but depends on the relative facts of the special case." In
other words, to a potential acquirer, due diligence means "making sure you
get what you think you are paying for."

Practically speaking, for any company acquisition,
due diligence would include fully understanding all of the obligations of
the company: debts, pending and potential lawsuits, leases, warranties,
long-term customer agreements, employment contracts, distribution
agreements, compensation arrangements, and so forth. Furthermore, for
software company investments and acquisitions, due diligence also includes

Understanding any ownership issues relative to the
software. For example, did the company really develop the software
themselves, or if they bought the technology, were the rights conveyed
properly? Does a former contract programmer have a potential claim on the
technology? Does the software depend on a library for which royalties must
be paid, or for which the owner might withdraw the rights? Might the
software infringe someone else's patents, perhaps inadvertently? Did all
employees execute confidentiality and non-compete agreements? Were
copyrights and trademarks registered properly?

Will there be any special issues in maintaining the
software? In integrating the software with the acquirer's existing
products?

Will the software be made obsolete quickly by hardware,
software, market or competitive changes?

"Due Diligence" typically takes the form of the acquirer's
list of several hundred questions and/or requests for copies of documents
that you, as the potential seller, must answer for the seller on or before
some date.

For the owner of a software company, due diligence can be
a very difficult and painful experience. It's difficult because you are
essentially trying to prove a negative, the absence of any problems. The
potential acquirer may keep coming back to you with more and move invasive
requests, until you are about ready to scream "do you think I'm a crook? I
told you we didn't have anything to hide!" Put yourself in the position of
someone who is spending millions of dollars for something they can't see and
can't touch, and perhaps you will understand a little better. It's painful
because it's hard not to be insulted by questions like "Have any of the
principals of the company ever been convicted of securities fraud? List all
criminal convictions of the principals of the company."

If you are the owner of a software company, the time to
start thinking about due diligence is now. Every decision that you
make, test it against the question "how will this look when someone comes
along asking hard questions?" Every software company is going to have
to go through due diligence someday — when
you are acquired, seek outside investment, or go public — unless you
intend to remain small and family-owner forever.

As a seller, you will also want to do your own due
diligence on the acquirer. Do they actually have the funds to complete the
transaction? If they are paying you with stock, what is the record of the
stock? Is it likely to still be worth anything when your lockup period
expires? How are they going to treat your employees? Are your corporate
cultures compatible? If there is a large "earn out" component to the deal
they are proposing, do they have a track record of successfully marketing
products like yours? What is their incentive to do so? Are you sure? What
happens if they do not? Will the acquisition stretch them
— in terms of capital, management or otherwise —
to the point that it will reduce their chances of success? Do they
have a reputation for living up to the letter and the spirit of their
commitments? How will they treat your customers? Will you be proud to be
associated with this company?

Sample Due Diligence list for
the acquisition of a software company. What a potential acquirer might
ask of you. Your acquirer will undoubtedly use their own list.

"How I Sold My Software Company"
— A PowerPoint presentation that gives a
very personal description of the process of selling my company. Includes a
description of the impact of due diligence..